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How Banks Contained The Oil Crash

Low energy prices have hit the American energy sector hard, with mounting debt and low profits leading to higher rates of loan delinquency and bankruptcies among oil and gas companies.

This has, in turn, generated concerns that major U.S. banks with high levels of exposure to the contracting energy sector will be hit by a wave of defaulted loans, possibly affecting growth in other sectors of the U.S. economy, which has been in slow but steady recovery since the financial crisis of 2008-2009. The high yield bond default rate for the energy sector has risen to 20 percent and evidence suggests that defaults in the energy sector could trigger higher defaults elsewhere, much like the housing collapse in 2007-2008 and the bursting of the tech bubble in 1999-2000.

Bankruptcies have spread throughout the American oil and gas sector. In many ways this was to be expected: when prices fell in July 2014, followed by a deeper crash in November after OPEC’s decision not to limit production, stress and strain among high-cost producers in the United States was the anticipated outcome. It is somewhat miraculous that shale producers and others in the U.S. patch have held on for this long: U.S. production held strong for months, peaking in April 2015 before beginning a long, slow decline.

The first quarter of 2016 saw the most corporate defaults since 2009. Major firms have declared bankruptcy. SandRidge Energy Inc. filed for Chapter 11 in mid-May, following Linn Energy’s Houston-based subsidiary and Samson Resources. Houston’s C&J Energy Services have received a temporary reprieve on their substantial debt, avoiding default and possible bankruptcy until June 30 when the grace period ends. By late May the tally of companies defaulting on loans had reached 72, half of which were within the energy sector. Again, it was the highest rate of corporate defaults since 2009.

Cause for concern? Perhaps; yet the financial sector has been bracing for the storm and with luck should emerge relatively unscathed. The same FDIC report that indicated a major fall in profits also pointed to a single major cause: a tremendous increase in provisions for loan and lease defaults, with the amount saved in reserve increasing by 50 percent, to $4.2 billion in Q1 of 2016. There was also a decline in non-interest income of $2.2 billion. Revenues increased by 2.7 percent and loan balances were up by 1.1 percent, indicating a generally healthy outlook for the banks. The mixed picture indicated “an evolving economic environment” according to FDIC Chairman Martin Gruenberg.

Other good news included a decrease in the number of banks on the FDIC’s “problem list,” indicating that fiscal health was improving throughout the financial sector. The number of banks on the list fell from 183 to 165, down from a high of 888 in 2011.

According to the American Bankers Association, major banks have shown an admirable degree of “prudent management,” adopting conservative positions in light of the trouble in the energy sector. Most of the debt within the energy industry is held by the major Wall Street banks, which paid out huge loans when the American oil and gas sector appeared on the verge of a technological revolution. Now that production is declining, the banks are reining in their lending. In recent months they have cut credit to energy companies substantially, forcing oil and gas firms to look for loans from third parties.

The major banks have been saving in the first quarter for the possibility of mass defaults. JP Morgan holds a loan-loss provision of $1.8 billion while Citigroup has retained $1.9 billion and Wells Fargo $1.1 billion. Bank of America (BOA), somewhat less conservatively, has saved only $997 million. All four banks have a total loan-loss provision over $11 billion each, anticipating defaults in their entire portfolio between 1.2 percent and 2.07 percent. Related: Clinton Campaign Pledges to Raise Fed Royalties for Oil Companies

The Federal Reserve has noted that banks have adopted fiscally conservative positions, anticipating a high level of defaults and taking adequate steps to counter such a development. JPM CEO Jamie Dimon announced that JPM would be increasing its reserves in the second quarter, but added that he did not think the amount “material.”

The Fed conducts a major stress test of the banks later this month, so more information as to their capacity to weather more storms in the energy sector is probably forthcoming. With prices hovering at $50 and a sense of bullishness slowly feeding into markets (OPEC’s continued failures notwithstanding), there is cause for reasonable optimism. For now, it seems unlikely that the pain felt by energy companies will migrate to other sectors of the American economy.

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